troylau's  Instablog

If you follow the daily movements of equities, you are often confronted with the case of the price of any given stock rising rapidly. In some of these instances you think to yourself, '...there's no reason for this rise, I know it is going to come back down...' In many cases it does come down, and you wish you had shorted when you had the chance. If only you had a good metric to REALLY know when this move was unjustified and were not forced  to act just on instinct.

Well, you're in luck because I'm going to give you just THAT.

In one of my earlier posts, I gave you the equation for my Share Strength Indicator (SSI), a measure of how much a single share could move the stock price.

http://thequantinvestor.blogspot.com/2011/03/share-strength-indicator-how-much-bang.html

Here, I stated how a high share strength was an indicator that a stock was susceptible to manipulation or uncharacteristically large moves. To test this, lets look at a strategy of shorting stocks that are UP on HIGH share strength. We will short a stock with:

1. A stock price being 10% or more above its 20 DMA price. 

2. A high share strength defined as 20 DMA share strength being greater than 2 standard deviations above the past year's average 20 DMA share strength.

And for the results....

Here we wait 20 days till we cover our short position, and for the results over the past 4 years...

Market          Price Change       Stocks Meeting Criteria

NYSE                 93%                          1980

Nasdaq               94%                          1272

AMEX                82%                            30

Scatter plot of returns for NYSE shorted stocks.

As you can see, once again we have impressive results. If the past 4 years are any indicator, a high share strength along with a big price increase makes for a good time to get in on the short side.

Two weeks ago, I demonstrated that the simple strategy of buying any stock at a 52 week high provided the fanciest of returns.

http://thequantinvestor.blogspot.com/2011/04/how-to-lose-money-by-buying-lowor-make.html

I expanded on that last week and showed some amazing gains with a refined strategy.

http://thequantinvestor.blogspot.com/2011/05/perfecting-strategy-of-buying-high.html

In response, I was asked by many readers if there were any specific sell rules, besides waiting a specific amount of time. There wasn't. To respond to my readers, in my post this week I'm going to examine whether, if by implementing a simple 'sell rule', we can further improve upon this already nice performance. For my sell rule, I'm going to implement William O'neil's hard and fast law of selling any stock that has taken an 8% loss, which is followed by many.

To implement my strategy I'll use my same rules as last week:

1. Buy any stock that is at a 52 week high

2. Hold for a specific period of time (1, 3, or 6  months I'll look at here)

3. Sell after that amount of time, or keep if it is still at a 52 week high

and I'll add another rule

4. Sell if, at any point, the stock drops me below an 8% loss (this INCLUDES intraday prices). To make it even more realistic I'll assume 1% slippage meaning I take a 9% loss when trying to sell at an 8% loss.

View my blog at http://thequantinvestor.blogspot.com/

Last week I demonstrated to my readers that a simple strategy of buying a stock at a 52 week high and holding for any given period of time, can be a very successful LONG investment strategy.

http://thequantinvestor.blogspot.com/2011/04/how-to-completely-outperform-market-by.html

Like any strategy it can be improved on, and in this post I'll try to do just that. Here I'll add another important consideration when buying a stock, the volume backing its price movement. To do that, let me introduce what I call the Volume Moving Average Ratio (VMAR). What this simply is, is the ratio of the 20 day volume moving average to the 75 day volume moving average (you can use other lengths of time as well):

VMAR = VMA(20 day) / VMA(75 day) 

What this tells us is how much the recent average volume is compared to the longer term volume. I used the simple moving average but an exponential would work as well. In theory, a VMAR >> 1 means a stock has significantly more investment activity than usual and, correlated with a price gain, indicates that perhaps its price movement IS warranted.

Now we could potentially cover a huge combination of VMARs and hold times. I'll leave it up to you, the reader, to find the best combination. But now I present to you two scenarios of short (1 or 3 month) hold times with VMARs greater than 1 or 2.

What we see is impressive...enormously impressive. In fact a strategy of 'buying high' backed with volume can make you a very wealthy person. Of course I make no promises, and any strategy that worked last decade may not this decade, and you should consider that. Also, don't forget commissions, as with any trading strategy, can easily take 1-2% off every trade. But these are the facts, and the numbers, and of that I am 100% certain. So here you go...enjoy!